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The Gross Income Requirement for Trusts’ Charitable Deductions

By Frances Schafer, J.D.

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Tax Section

Editor: Greg Fairbanks, J.D., LL.M.

Estates,
Trusts & Gifts

Trusts are hybrids of
entities that pay tax on all their income, like
corporations, and entities that pass all their
income through to others, like partnerships.
Trusts are taxed on income that is retained by
the trust and receive a distribution deduction
for income treated as distributed to the
beneficiaries. The beneficiaries are then taxed
on the income that is treated as distributed to
them. Only beneficiaries who receive
distributions of a specific sum of money or of
specific property are exempt from the income
distribution rules. For other beneficiaries,
trusts are generally not required to trace the
source of distributions made to them because the
concept of distributable net income, introduced
in the Internal Revenue Code in 1954, eliminates
the need for such tracing. Distributable net
income operates by presuming that distributions
are made first from income and allocating that
income among the beneficiaries receiving
distributions.

Distributions from a trust
to charitable organizations are not considered
distributions to beneficiaries for purposes of
the distribution deduction (Regs. Sec.
1.663(a)-2). (See also U.S. Trust
Co., 803 F.2d 1363 (5th Cir. 1986); Mott, 462
F.2d 512 (Ct. Cl. 1972); Rev. Rul. 68-667; and
Rev. Rul. 2003-123.) Rather, distributions to
charities are deductible only if they meet the
requirements of Sec. 642(c).

Under Sec.
642(c)(1), a trust is allowed a deduction in
computing its taxable income for any amount of
gross income, without limitation, that under the
terms of the governing instrument is, during the
tax year, paid for a charitable purpose. Because
a charitable deduction is available only if the
source of the contribution is gross income,
tracing the contribution is required to
determine its source. As the Tax Court explained
in Van
Buren, 89 T.C. 1101, 1109 (1987):

Tracing is
required since the statute specifically requires
that the source of the contribution be gross
income. See Riggs National
Bank v. United States, 173 Ct. Cl. 479,
352 F.2d 812, 814 (1965). This specific
reference forms the basis for a limited
exception to the general removal of the tracing
requirement accomplished by subchapter J. The
exception is limited to the area of charitable
deductions. See Mott, 199 Ct.
Cl. 127, 462 F.2d 512, 518–519 (1972).

In
Rev. Rul. 2003-123, the trust owned parcels of
real estate that had been transferred to the
trust at its formation. The terms of the trust
agreement authorized the trustee to make
charitable contributions, and under this
authority the trustee conveyed to a charitable
organization a perpetual conservation easement
in one parcel of real estate. The easement met
the definition of a qualified conservation
easement under Sec. 170(h) and thus was a
transfer for a charitable purpose. The value of
the easement did not exceed the trust’s gross
income for the year of the contribution. The
ruling concludes that it is necessary to trace
the source of the contribution in order to
determine whether its source is from the trust’s
gross income. In the facts of the ruling, the
source of the contribution was from property
originally contributed to the trust and was not
from gross income. As a result, the gross income
requirement of Sec. 642(c)(1) was not met, and
the trust was not entitled to a charitable
deduction for the value of the easement.

But what would have happened if the trust had
purchased the property with amounts that were
gross income in the past? Is there a requirement
that the contribution must be traced to the
current year’s gross income? Rev. Rul. 2003-123
assumed a factual situation in which the
property transferred to charity was an interest
in property that had originally been contributed
to the trust. As such, there was no possibility
that the property contributed to charity could
be traceable to gross income of the current year
or any prior year.

The question of
whether it is permissible to trace the source of
the contribution back to the trust’s gross
income earned in years prior to the year of
contribution is discussed only in very old
cases. One of the two issues before the Supreme
Court in Old
Colony Trust Co., 301 U.S. 379 (1937),
was whether the trust had to show that
contributions to charity were made out of gross
income received by the trust in the year the
contributions were made. The trustee kept a
separate account of accumulated and
undistributed income and charged the charitable
contribution in question to that account. Even
though the Supreme Court was interpreting
Section 162(a) of the Revenue Act of 1928, a
predecessor of Sec. 642(c), the language in both
sections is substantially similar—i.e., the
trust is allowed a deduction for “any part”
(rather than “any amount”) of the gross income,
without limitation, which under the terms of the
deed of trust is paid for a charitable purpose.
The Supreme Court, in concluding that the
trustee did not need to prove that the
charitable contributions were made from the
current year’s income, stated:

This language
should be construed with the view of carrying
out the purpose of Congress—evidently the
encouragement of donations by trust estates.
There are no words limiting these to something
actually paid from the year’s income. And so to
interpret the Act could seriously interfere with
the beneficent purpose. One creating a trust
might be unwilling to bind it absolutely to pay
something to charity but would authorize his
trustee so to do after considering then existing
circumstances. Capital and income accounts in
the conduct of the business of estates are well
understood. Congress sought to encourage
donations out of gross income, and we find no
reason for saying that it intended to limit the
exemption to sums which the trust could show
were actually paid out of the receipts during a
particular year. The design was to [forgo] some
possible revenue in order to promote aid to
charity. Here the trustee responded to an
implied invitation and the estate ought not to
be burdened in consequence. [Old Colony Trust
Co., 301 U.S. at 384]

Subsequently, in W.K. Frank Trust
of 1931, T.C. Memo. 43-516 (1943),
aff’d, 145 F. 411 (3d Cir. 1944), a trust gave
to charity stock that it had received in a
tax-free liquidation of a corporation, the stock
of which had been originally contributed to the
trust. The taxpayer argued that based on the
Old
Colony decision, it was immaterial that
the trust made the gifts to charity from trust
corpus rather than income. The Tax Court
stated:

We do
not believe, however, that the above case stands
for such a proposition. The Supreme Court was
not there concerned with the question of whether
the gifts were made out of corpus or out of
income. It was concerned only with the question
of whether they were made out of particular
receipts of income.

Thus, the Tax Court
interpreted Old Colony
as not eliminating the requirement that
the contributions be made out of income and not
corpus, but as merely not requiring the
contributions to be made out of the current
year’s income. Because the shares contributed to
charity by the Frank Trust were corpus of the
trust, the Tax Court concluded that no
charitable deduction was allowed to the
trust.

In affirming the Tax Court’s
decision, the Third Circuit determined that the
contributed shares were part of the corpus of
the trust and were never income despite the
trustees’ having charged the value of the
distributed shares against income on the trust’s
books. That court stated that the trustees’
resolution to charge the distributed shares
against income of the trust did not convert
corpus into income. The Third Circuit also noted
that the contributed shares were worth more at
the time they were gifted to charity than they
were when the trust received them but that
“[s]uch appreciation in value, unrealized by
sale or other disposition, was not gross income”
(W.K. Frank
Trust, 145 F. at 413).

The Old Colony
decision itself and the Tax Court’s
interpretation of that decision in W.K. Frank
Trust support the position that while a
trust’s charitable contribution must be
traceable to gross income, it does not have to
be gross income earned in the year of the
charitable contribution. Based on these cases, a
trust’s charitable deduction should not be
limited to distributions to charity of amounts
of gross income earned in the year that they are
contributed to charity. In Chief Counsel Advice
(CCA) 201042023, the IRS signals for the first
time its agreement with that interpretation.

In the CCA, the trust had purchased three
properties with the prior year’s gross income
and could trace the source of the purchases to
that gross income. The terms of the trust
agreement authorize the trustee to distribute to
charity such amounts from gross income as the
trustee determines to be appropriate. After the
properties had appreciated in value, the trust
contributed them to three charitable
organizations.

The trust claimed a
deduction equal to the current fair market value
of the three properties at the time of their
contribution to the charitable organizations.
The CCA acknowledged the court decisions holding
that it is not necessary for a trust to make the
charitable contribution from the current year’s
gross income as long as the contribution can be
traced to gross income earned in the past. The
amount of gross income embedded in the
properties contributed to charity equaled the
trust’s adjusted basis in the properties
purchased with gross income. The CCA concluded
that the trust’s charitable deduction for
property contributed to charity is limited to
the trust’s adjusted basis in the property that
had been purchased from the trust’s gross income
and that no charitable deduction is available
for the amount of unrealized appreciation in the
value of the properties since their
purchase.

Practice
tip: Just a reminder that trusts claiming
a charitable deduction under Sec. 642(c) for the
tax year are generally required to file Form
1041-A, U.S. Information Return Trust
Accumulation of Charitable Amounts, to satisfy
their filing requirement under Sec. 6034(b)(1).
Exceptions to this filing requirement are for
trusts if all the net income for the year is
required to be distributed currently to the
beneficiaries (see Sec. 6034(b)(2)(A)) and for
trusts described in Sec. 4947(a)(1) (wholly
charitable trusts) (see Sec. 6034(b)(2)(B)). In
addition, for tax years beginning after 2006,
trusts that are split-interest trusts described
in Sec. 4947(a)(2) (charitable lead trusts,
charitable remainder trusts, and pooled income
funds) are required to file only Form 5227,
Split-Interest Trust Information Return, and not
Form 1041-A (see Sec. 6034(a)).

Thus, a
trust that is not required to distribute all its
income currently or is not a wholly charitable
trust is required to file Form 1041-A for any
year in which it claims a charitable deduction
under Sec. 642(c). This filing requirement is
also applicable to a trust that does not itself
contribute directly to charity but that claims a
charitable deduction for the trust’s
distributive share of gross income paid to
charity by a partnership or an S corporation in
which the trust owns an interest.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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